There are essentially two main categories of inventory costs; the first includes inventory carrying costs and the second includes lost sales. One covers the high costs of holding inventory without sufficient sales volumes, while the other itemizing the high costs of losing sales without sufficient inventory. One is easily understood in terms of its financing, while the other is less understood because companies don’t properly track the costs of losing business. Now, most companies thoroughly understand the high costs of holding inventory, but far too few ever track the high costs of not having inventory. What are these costs?
Focus on Your Business Model
One of the biggest issues I see with respect to inventory is how companies run an inventory and supply chain strategy that is completely contrary to their business model. Yes, I’ve repeated this several times on this site, but it’s something that must be clearly understood by everyone; define your business model first, your inventory costs second and third, decide upon an inventory strategy that best matches your business model and reduces your company's costs. However, to do that requires you track those two aforementioned main categories of inventory costs; 1) the costs of holding inventory without sales, and 2) the costs of losing sales without inventory.
1. Costs of Holding Inventory Without Sales: This list is rather easy. First, there are your company’s costs of inventory financing; everyday you hold inventory and can’t make a sale, is yet another day where your company must absorb its cost of capital. Second, there are the high costs associated with inventory damage. Third, there are the high costs of inventory obsolescence. Fourth, there are costs for incoming shipments of raw materials, parts and finished goods and your company’s per-unit freight costs to get those shipments into your warehouse. Finally, there are costs pertaining to warehousing, electricity and handling and counting inventory. These costs are what most associate with a company's costs to manage its inventory.
“The longer your company holds inventory, the more likely it is to encounter damage, obsolescence and high financing.”
2. Costs of Losing Sales Without Inventory: As mentioned, most companies ignore, are unaware, or simply refuse to tract the second category of inventory costs. Not having inventory is a direct cost of inventory. Yeah, that’s probably hard to fathom. To help, here’s a brief description of these costs. First, there are costs that pertain to lost sales and lost gross profit. Second, there are high freight costs when your company doesn’t have the inventory it needs, and must therefore rush parts in to meet demand, and then rush parts out to satisfy an unhappy customer. Third, there are costs pertaining to warehouse and production overtime when your company must rush these parts and raw materials in to meet demand. Finally, there costs pertaining to losing customers and losing business volumes.
“When you don’t have enough inventory, you must rush parts in to meet demand, cover the costs of overtime and then rush finished goods out to your customer.”
Why Do Companies Ignore the Second Category?
Understanding the first category is rather straightforward. Every company understands the high costs of inventory financing, damage and obsolescence. However, very few understand the costs associated with having low inventory counts. This is why tracking your company’s unique inventory costs is so important when it comes to protecting your company’s bottom line. Track these costs first and then match an inventory strategy that meets your company’s unique needs.
A good rule of thumb is to understand that any cost of managing inventory can be seen as a cost of inventory. For instance, what does your company do when lacking the inventory to meet customer demand – especially for important customers? Well, you’ll immediately rush parts in from your supplier.
This will likely have an expedite fee attached to it. Next, you may have to pay someone overtime to receive, count and stock the parts. Perhaps you’ll have to pay manufacturing overtime because you ignored the high costs of material shortages. Next, in order to salvage the relationship, you’ll probably have to expedite that shipment to your customer for being late. Now, did having low inventory really save you money?
To read about how an inventory analyst position can help you find a balance between high carrying costs, and lost sales, please read: Small Business Inventory Asset Management: Using an Inventory Analyst
To better understand these two inventory costs in a graph format, then please read: The Bell Curve of Inventory Management: Finding the Middle Ground
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